ECO-6655: Application Problem Set 5 SOLUTIONS, T5-1 !r" !

ominic #" $ina%eo

Make sure you show ALL your work and explain where asked. Groups who do not provide
explanations or simply provide final answers will not receive credit for that question. See the
assignment handout for more information.
Groups should answer the following questions:
1. &'( Point)* Indicate whether each of the following statements is true or false and explain why.
A. A monopolistically competitive firm that is incurring a loss should immediately cease operations.
#ALSE" In t+e )+ort r,n, it )+o,l% contin,e to operate a) lon- a) t+e lo))e) earne% a) le)) t+an
T#C" In t+e lon- r,n, +o.e/er, it ma0 nee% to con)i%er %roppin- o,t o1 t+e mar2et i1 t+e price
%oe) not ri)e e3,al to or abo/e a/era-e co)t"
B. A monopoly will always earn economic profit because it is able to set its prices at any level it
desires.
#ALSE" 4+ile monopolie) %o +a/e mar2et po.er, t+e0 are )till ),b5ect to t+e la. o1 %eman%, )o
t+e0 can6t c+ar-e 5,)t an0 price b,t to ma7imi8e pro1it m,)t ba)e price) c+ar-e% ba)e% on
con),mer .illin-ne)) to pa0" #,rt+ermore, .+ile a monopol0 can earn pro1it) in t+e )+ort or lon-
r,n, .+et+er pro1it) are earne% %epen%) on t+e %eman% 1or t+e pro%,ct o/er time" !eman% can
%ecrea)e, an% i1 t+i) occ,r), price) an% pro1it) .ill 1all" O1ten in t+e lon-er r,n, monopol0 pro1it)
are ero%e% b0 competition or c+an-e) in tec+nolo-0, )o pro1it) are b0 no mean) -,arantee% e/en
1or a monopol0"
C. In the long run, firms operating in perfect competition and monopolistic competition will tend to
earn normal profits.
T9UE" Entr0 or e7it o1 1irm) .ill t+eoreticall0 lea% to t+i) con%ition" T+e onl0 e7ception .o,l%
be in t+e ca)e .+ere a 1irm +el% )ome ,n,),al a%/anta-e, or )imple l,c2"
D. Assuming a linear demand curve, a firm that wants to maximie its revenue will charge a lower
price than a firm that wants to maximie its profits.
T9UE" In or%er to ma7imi8e re/en,e, 1irm) .ill price t+eir pro%,ct at t+e point .+ere $9 :
8ero" ;0 implication, t+i) m,)t be a lo.er price t+an t+e point .+ere $9 : $C"
!. "hen a firm is able to sets its price, its price will always be less than #$.
#ALSE" 4+en t+e %eman% c,r/e i) %o.n.ar% )lopin-, t+e price c+ar-e% i) -reater t+an mar-inal
re/en,e" T+i) i) beca,)e in or%er to )ell more ,nit), t+e 1irm m,)t lo.er it) price on all ,nit) )ol%,
)o $9 1all)"
%. &'( Point)* &un City, Ariona, a retirement community that features full'service living arrangements,
is considering two proposals to provide lawn'care to elderly residents. (irst, a national lawn'care
firm has offered to purchase the city)s lawn'care e*uipment at an attractive price in return for an
exclusive franchise on residential service. A second proposal would allow several small companies to
enter the business without any exclusive franchise agreement or competitive restrictions. +nder this
plan, individual companies would bid for the right to provide service in a given neighborhood. ,he
city would then allocate business to the lowest bidder.
,he city has conducted a survey of &un City residents to estimate the amount they would be willing to
pay for various amounts of lawn service. ,he city has also estimated the total cost of service per
resident. &ervice costs are expected to be the same whether or not an exclusive franchise is granted.
1
ECO-6655: Application Problem Set 5 SOLUTIONS, T5-1 !r" !ominic #" $ina%eo
SL!"#$:
A. +se the indicated price and total cost data to complete the following table.-red font .
answers/
%ours of
Lawn
&are per
Month
'rice per
%our
"( M( "& A"& M& 'rofit
( <''"5( ("(( ---- < ("(( ---- ----
1 <'1"=5 '1"=5 <'1"=5 '1"(( '1"(( '1"(( ("=5
' <'1"(( >'"(( <'("'5 >("5( '("'5 1?"5( 1"5(
<'("'5 6("=5 <1@"=5 5@"5( 1?"5( 1@"(( '"'5
> <1?"5( =@"(( <1="'5 =5"=5 1@"?> 1="'5 '"'5
5 <1@"=5 ?"=5 <15"=5 ?'"'5 1@">5 16"5( 1"5(
6 <1@"(( 1(@"(( <1>"'5 1(="'5 1="@@ 15"(( ("=5
= <1="'5 1'("=5 <1'"=5 1'("=5 1="'5 1"5( ("((
@ <16"5( 1'"(( <11"'5 1'"(( 16"5( 11"'5 ("((
? <15"=5 1>1"=5 <?"=5 15("(( 16"6= 1@"(( -@"'5
B. Determine price and the level of service if competitive bidding results in a perfectly
competitive price0output combination.
In a per1ectl0 competiti/e in%,)tr0, t+e lon- r,n price an% o,tp,t le/el occ,r) .+ere P :
minim,m ATC, .+ic+ in t+i) ca)e i) A : @ +o,r) o1 la.n care per mont+" Pro1it in t+i) ca)e
i) 8ero )ince P : ATC"
C. Determine price and the level of service if the city grants a monopoly franchise.
A monopol0 .ill ma7imi8e pro1it) b0 )ettin- $9 : $C" Bere, $9 : $C : <5"=5 at A : >
+o,r) o1 la.n care per mont+ an% P : <1?"5( per +o,r" Note: Alt+o,-+ $C tec+nicall0
+a)nCt reac+e% it) minim,m 0et, t+e monopol0 +a) t+e abilit0 to )et price) +i-+er t+an 1irm)
in competiti/e mar2et) an% can earn a pro1it re-ar%le))" T+e0 re)trict o,tp,t an% increa)e
price) a) a re),lt" Pro1it : &<1?"5( - <1@"?>* D > : <'"'5"
1. &'( Point)* 2aradox Dental, 3td., en4oys a local monopoly in the provision of oral examination
services in ,us5egee, Alabama. ,otal and marginal revenue relations for the standard procedure are6
,$ . 7%89: ' 79.991:
%
#$ . d,$0d: . 7%89 ' 79.99%:
#arginal -. average variable/ costs for the process are stable at 7189 per unit. (ixed costs are ero.
A. As a monopoly, calculate 2aradox Dental)s output, price, and profits at the profit'
maximiing activity level.
B. "hat price and profit levels would prevail based on the assumption that new entry into the
local mar5et results in competitive mar5et pricing;
SOLUTION:
A" Set $9 : $C to 1in% t+e pro1it-ma7imi8in- acti/it0 le/el:
$9 : $C, or <'5( - <("(('A : <15(
("(('A : 1((, or A : 5(,(((
P : T9EA : &<'5(A - <("((1A
'
*EA : <'5( - <("((1A : <'5( - <("((1&5(,(((* : <'((
'
ECO-6655: Application Problem Set 5 SOLUTIONS, T5-1 !r" !ominic #" $ina%eo
: T9 - TC : <'((&5(,(((* - <15(&5(,(((* : <',5((,(((
;" In a per1ectl0 competiti/e in%,)tr0, P : $9 : $C in e3,ilibri,m" T+,), a1ter t+e emer-ence
o1 competiti/e mar2et pricin-, P : $C : <15( .o,l% re),lt" ;eca,)e $C : AC, P : $C
implie) t+at : ("
>" &1( Point)* In t+e 1ollo.in- li)t i) a n,mber o1 .ell-2no.n companie) an% t+e pro%,ct t+at t+e0 )ell"
4+ic+ o1 t+e 1o,r t0pe) o1 mar2et) &per1ect competition, monopol0, monopoli)tic competition,
oli-opol0* be)t c+aracteri8e) t+e mar2et) in .+ic+ t+e0 competeF E7plain .+0" Bint: Go, ma0 .i)+ to
%i)tin-,i)+ bet.een national an% localEre-ional mar2et) 1or )ome 1irm)" &re% 1ont : )ol,tion)*
a" #cDonald<s ' hamburgers: Oli-opol0 in t+e national &or .orl%.i%e* 1a)t 1oo% mar2et, b,t
monopoli)tic competition in t+e local or per+ap) re-ional mar2et)"
b" !xxon'#obil ' gasoline6 Oli-opol0 in t+e national &or .orl%.i%e* oil re1iner0 mar2etH
monopoli)tic competition in t+e local retail mar2et &nei-+bor+oo% -a)oline )tation)*"
c" Dell ' personal computers: $onopoli)tic competition" T+e top 1i/e comp,ter man,1act,rer)
&!ell, Compa3, I$;A, BP, an% Iate.a0* +a/e le)) t+an 5(J o1 t+e PC mar2et int +e US, a)
.ell a) in t+e .orl% mar2et"
%" =ein ' 5etchup6 Oli-opol0 &almo)t a %,opol0i1 0o, t+in2 abo,t Bein8 an% !el $onte
e))entiall0 %ominatin- t+e 2etc+,p mar2et*"
e" 2roctor > ?amble ' disposable diapers6 Oli-opol0 &main competitor to Proctor6) Pamper) i)
Kimberl0-Clar26) B,--ie)*" Bo.e/er, pri/ate label %i)po)able %iaper) are increa)in- t+eir
mar2et )+are)"
1" &tarbuc5s ' gourmet coffee6 $onopoli)tic competition" Starb,c2) ma0 be alone a) a national
c+ain, b,t in local mar2et) t+ere are n,mero,) -o,rmet co11ee+o,)e)"
-" Domino<s ' pia6 Oli-opol0 in national pi88a c+ain)" $onopoli)tic competition at t+e local
le/el"
+" Intel ' computer chips for 2C<s6 Oli-opol0, b,t beca,)e o1 Intel6) %ominance in t+i) mar2et, it
co,l% be calle% a LnearM monopol0"
8. &( Point)* Bow "ow Baaar -B"B/ is a growing firm specialiing in gourmet dog food and supplies
in (lorida resort communities. B"B)s demand and cost information are as follows6
2 . @899 ' :
#$ . @899 ' %:
,C . 189,999 A @99:
#C . 7@99
where : is output, 2 is price in dollars, #$ is marginal revenue, ,C is total cost and #C is marginal
cost. All costs include a normal return of 1%B on capital investment.
A. Determine the profit'maximiing price and output levels, and the profit earned.
Set $9 : $C to %etermine t+e pro1it-ma7imi8in- o,tp,t le/el:
>5(( - 'A : >((, or 'A : >1((, )o A : '(5( ,nit)
P : >5(( - A : >5(( - '(5( : <'>5(
Pro1it : T9 - TC : PDA - TC
: &>5((-A*A - &15(,((( N>((A*
: >5((A - A
'
- 15(,((( - >((A

ECO-6655: Application Problem Set 5 SOLUTIONS, T5-1 !r" !ominic #" $ina%eo
: N>1((A - A
'
- 15(,(((
: >1((&'(5(* - &'(5(*
'
- 15(,(((
: @,>(5,((( - >,'(',5(( - 15(,((( : <>,(5',5((
B. Based on your results in 2art A and assuming the firm operates in a monopolistically competitive
industry, explain what will happen to this industry in the long run; No, t+e 1irm i) not in lon--r,n
e3,ilibri,m )ince it i) earnin- ),b)tantial economic pro1it) at pre)ent" T+e)e pro1it) .ill attract
ne. 1irm) to t+e lan%)capin- in%,)tr0, .+ic+ .ill attract b,)ine)) a.a0 1rom ;4; an% )+i1t
;4;C) %eman% c,r/e le1t.ar% o/er time &i"e", t+eir mar2et )+are .ill 1all*" T+i) entr0 .ill
contin,e ,ntil ;4;C) economic pro1it) are eliminate%"
C. Determine the output level, price, and profits that will occur in long'run e*uilibrium. Assume a
high'price, low'output scenario assuming a parallel shift of the firm<s demand curve. Be sure to
explain what you are doing and why. =int6 ,he slope of the A,C curve is '7189,9990:
%
.
Step 1: In t+i) problem, t+e ori-inal %eman% c,r/e .ritten in term) o1 P : >5(( - A, )o .e nee%
to re.rite t+e ori-inal %eman% c,r/e in term) o1 A, or A : >5(( - P" T+i) mean) t+e )lope o1 t+e
%eman% c,r/e i) -1 an% t+e ori-inal intercept i) >5((" #,rt+ermore, t+e problem )peci1ie) a
parallel )+i1t o1 t+e %eman% c,r/e, )o t+e ne. %eman% c,r/e intercept c+an-e) b,t t+e )lope
remain) t+e )ame" 4e %o not nee% to %etermine t+e intercept at t+i) point beca,)e .e are onl0
intere)te% in t+e )lope o1 t+e %eman% c,r/e to )ol/e t+i) problem"
Step ': #in% t+e point o1 tan-enc0 bet.een t+e ATC c,r/e an% t+e %eman% c,r/e" T+i) occ,r)
.+ere t+e )lope o1 t+e ATC c,r/e &: -<15(,(((EA
'
* e3,al) t+e )lope o1 t+e ne. %eman% c,r/e:
)lope o1 co)t c,r/e : ne. %eman% c,r/e )lope
-<15(,(((EA
'
: -1
A
'
: 15(,(((
A : )3,are root o1 15(,((( : @="'?@ ,nit)"
Step : In lon--r,n e3,ilibri,m, P : AC:
P : AC : TCEA
: &15(,((( N >((A*EA : 15(,(((EA N >((
: 15(,(((E@="'?@ N >(( : @="'?@ N >(( : <=@="'?@
Step >: In t+e lon- r,n, pro1it) are 8ero" To pro/e t+i):
Pro1it : T9 - TC : PA - 15(,((( - >((A
: &=@="'?@*D@="'?@ - 15(,((( - >((&@="'?@*
: (>,?1?" - 15(,((( - 15>,?1?" : 8ero
Cote6 If you got a small positive number it li5ely is due to rounding error.
D. Calculate B"B)s new long'run e*uilibrium demand curve.
In or%er to -et t+e ne. %eman% c,r/e, .e6ll nee% to %etermine t+e intercept" 4e 2no. t+at one point
on t+e %eman% c,r/e alrea%0 i) P : @=" an% A : @=", an% .e al)o 2no. t+at %eman% c,r/e) are o1
t+e 1orm A : a - bP, an% .e alrea%0 %etermine% t+at b : -1 1rom part ;"
S,b)tit,tin- t+e)e /al,e): @=" : a - =@=", t+en a : 11=>"6" T+ere1ore, A : 11=>"6 - P i) ;4;C)
ne. %eman% c,r/e"
>
ECO-6655: Application Problem Set 5 SOLUTIONS, T5-1 !r" !ominic #" $ina%eo
Alternati/el0, t+e in/er)e %eman% c,r/e .ritten in term) o1 P : 11=>"6 - A" Notice t+at t+e intercept
term +a) %ecrea)e% ),b)tantiall0 1rom t+e ori-inal one &P : >5(( - A*, in%icatin- a mar2e% le1t.ar%
)+i1t o1 t+e c,r/e %,e to mar2et entr0"
5